I’ve heard that sponsors of qualified retirement plans can offer life insurance as a type of investment within the plan. If that is true—what are the requirements to do so?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.  A recent call with a financial advisor in Colorado is representative of a question we commonly receive related to life insurance in qualified plans.

Highlights of Discussion

While life insurance is prohibited within IRAs, it is true that some qualified plans permit participants to purchase life insurance with a portion of their individual accounts within their workplace retirement plans. [See Treasury Regulation §§1.401-1(b)(1)(i) and (ii).]

If life insurance is offered as an investment within a retirement plan, the following are some critical points to keep in mind.

Death benefits must be “incidental,” meaning they must be secondary to other plan benefits. For defined contribution plans, life insurance coverage is considered incidental if the amount of employer contributions and forfeitures used to purchase whole or term life insurance benefits under a plan are limited to 50 percent for whole life, and 25 percent for term policies. No percentage limit applies if the participant purchases life insurance with company contributions held in a profit sharing plan for two years or longer. [See IRS Revenue Ruling 54-51  and PLR 201043048.

For a defined benefit plan, life insurance coverage is generally considered incidental if the amount of the insurance does not exceed 100 times the participant’s projected monthly benefit.

If the plan uses deductible employer contributions to pay the insurance premiums, the participant will be taxed on the current insurance benefit. This taxable portion is referred to as the P.S. 58 cost. Insurance premiums paid by self-employed individuals are not deductible.

A participant with a life insurance policy within a retirement plan, generally, may not roll over the policy (but he or she may swap out the policy for an equivalent amount of cash, and roll over the cash).

Participants may exercise nonreportable “swap outs.” In a life insurance swap out, the participant pays the plan an amount equal to the cash value of the policy in exchange for the policy itself. This transaction allows the participant to distribute the full value of his or her plan balance (including the cash value of the policy), and complete a rollover, while allowing the participant to retain the life insurance policy outside of the plan.

Swap Out Example:

Anne has a life insurance contract in her 401(k) plan with a face value of $150,000, and a cash value of $25,000. She elects to swap out the policy and gives the administrator a check for $25,000. In return, the administrator reregisters the insurance policy in Anne’s name (rather than in the plan’s name), and distributes the contract to her. There is no taxable event and Anne may take a distribution (once she has a triggering event) and roll over the entire amount received if that is in her best interest.

Conclusion

It is possible that a qualified retirement plan may allow participants to invest in life insurance under the plan. Check the terms of the document to determine whether it is an option and follow the incidental benefit rules.